Warren Buffett Sounds the Alarm on Accounting Shenanigans

Warren Buffett’s comments on earnings quality is something the CFA Institute has been teaching for years

Warren Buffett recently released his annual letter to shareholders (downloadable here) and used the event to highlight a huge problem in financial reporting. As he asked investors to overlook a portion of GAAP amortization costs that depressed Berkshire profits, Buffett warned that he was hesitant to join a practice that is too common in financial reporting.
“But it is with some trepidation that I do that, knowing that it has become common for managers to tell their owners to ignore certain expense items that are too real.” (page 16)
Promoting non-GAAP results has become commonplace to smooth fluctuations from one-time items like write-downs, restructuring and pension fund contributions. The problem is that the practice may be getting out of hand. More than half the companies in the S&P 500 beat earnings estimates in the most recent quarter while more than half missed revenue expectations…that suggests some financial shenanigans and analysts need to take notice.
How Companies Trick Investors with Questionable Earnings Quality
Buffett calls out stock-based compensation as the “most egregious example” of earnings adjustments arguing that removing this as an expense is ridiculous. He’s right. I’ve always marveled at the audacity of management that’s tried to convince investors that this form of compensation is anything but an expense. While it may be a non-cash expense, it still has a significant effect on ownership and earnings.
Aswath Damodaran posted an excellent review of how companies, particularly Twitter, are inflating their adjusted EBITDA by adding back stock-based compensation. The company added back $521 million in compensation to arrive at adjusted (Non-GAAP) net income, helping Twitter to post a profit for the quarter. Stock-based compensation is not an ‘extraordinary’ expense, especially for fast-growing tech firms like Twitter.
Buffett doesn’t let analysts off the hook and says they, “often play their part in this charade, too, parroting the phony, compensation-ignoring “earnings” figures fed them by management.” Whether the analysts don’t know any better or don’t want to lose access to management, Buffett says they are “guilty of propagating misleading numbers that can deceive investors.”
Buffett also says investors should suspect the rationale of adding back depreciation charges to arrive at an EBITDA measure of profitability. For capital intensive companies, the mismatch between large capital investment and the depreciation charge leads to even GAAP earnings being higher than true economic earnings.
While EBITDA is supposed to provide a clean view of the company’s earnings power, it is here that a lot of manipulation occurs and you should do your own adjusting to find a company’s true EBITDA. Vice Chairman of Berkshire Hathaway and Buffett friend Charlie Munger has himself said that, “every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.”
Analysts at Bank of America/Merrill Lynch sounded the alarm earlier this year as well. BofA found that 90% of companies are now reporting “adjusted” earnings, up from just 70% in 2010. Besides the need to constantly reach for more transparency in earnings, the trend may be an immediate threat as well. GAAP earnings have been negative for three of the last four quarters though “adjusting” earnings might be holding up investor sentiment artificially. Analysts need to see through the manipulation and present the case factually to investors or the whole house of cards may come crashing down very soon.
The CFA curriculum has included measures of earnings quality and income statement manipulation for years. Make sure you pay attention to the material on accounting shenanigans and the aggregate accruals formulas in the Level 2 CFA curriculum. Also, pay attention to the calculation of economic profit and how it differs from other earnings measures. Don’t be complicit in management’s game and give your clients the transparency they deserve.
‘til next time, happy analysis!
Joseph Hogue, CFA

For general inquiries, please write to us at info@finquiz.com. For pre-sales inquiries, get in touch at sales@finquiz.com.

CFA Institute does not endorse, promote or warrant the accuracy or quality of FinQuiz. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute. BA II Plus is registered trademark owned by Texas Instruments.

Copyright © 2008-2020 FinQuiz:CFA Exam Prep. All rights reserved.
Terms and Conditions | Privacy Policy | Blog | Contact Us | FAQs | Changes | IFRS vs GAAP